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Governments bent on cooling home prices could get more than they bargain for

Published on March 1, 2018 in the Financial Post

Haider Moranis Bulletin: A steep decline could blast a big hole in revenues, but the real caveat is unintended consequences

Do falling housing prices eventually impact local and provincial revenue?

While governments in Canada are focused on arresting the growth in housing prices to promote affordability, the unintended consequences of steeper-than-envisioned declines also merit consideration.

Municipal and provincial revenues are tied to property taxes, and as housing values decline, property-related tax revenues decline as well. The costs of delivering municipal services, however, continue to increase, often at a rate higher than the rate of inflation.

Such divergence in costs and revenues at the local government level creates a funding gap that is often plugged by the higher tiers of government. However, a steep and sustained decline in housing prices will impact revenues of higher tiers of governments as well, limiting their abilities to offer adequate support to local governments.

Howard Chernick and co-authors presented a paper at the Urban Institute in 2017 where they examined the adverse impact of declining housing values on local government revenues.

Their analysis of 91 cities in the United States revealed that since the Great Recession, which was marked by a collapse of housing markets, “inflation-adjusted per capita revenues and spending remaine(d) below their pre-recession levels” in many of those cities.

And even when local tax revenues rose, cuts in federal funding to local governments worsened the fiscal challenges faced at the municipal level.

In the latest tightening of housing market regulations in Canada, the B.C. government has proposed even higher transfer tax rates on foreign homebuyers and new annual levies on homeowners who are not residents of British Columbia.

These additional surcharges have been announced within weeks of the tightening of mortgage regulations that require federally regulated lenders to subject all borrowers to a stress test that includes qualifying at a mortgage rate significantly higher than the contracted rate.

The cumulative effect of tighter mortgage regulation and “speculation” taxes has been a softening of the housing market in Vancouver and Toronto where prices and sales declined significantly.

Have the declining housing values impacted municipal revenues in Vancouver? Not yet.

The reason for the municipal revenue resilience is the lag between assessed property values and market values. Often the assessed values lag market values by a few years. Even when market values are falling, assessed housing values may continue to rise.

Consider Vancouver, where housing prices in 2017 declined compared to housing prices in 2016. However, the assessed residential property values increased by 32 per cent in 2017 resulting in a moderate increase in property tax revenue.

When property values continue to decline, assessed values eventually catch up, and a decline in property tax revenue ensues. A countermeasure could be an increase in the property tax rate or greater transfer of funds from higher tiers of government.

Announcing the new restrictions on housing markets earlier, Carole James, the B.C. Finance Minister, explained that their goal was to affect a decline in housing prices. Just how steep that decline will be is an important question especially when the tightening of regulations might force many borrowers underwater where their mortgage loans would be larger than the fallen housing values.

The minister acknowledged that the Finance Ministry had not modelled the scale and scope of the impacts of the new regulations. “We’re taking some very bold steps.… There are firsts here,” the minister said.

Declining housing prices impact other sources of revenue. First comes the decline in land-transfer tax revenue, which is based on sold prices and not assessed values. Next is the decline in sales tax revenue, because of depleting housing equity. And finally, a sustained drop in property values contribute to lower assessed values resulting in a drop in property tax revenue.

The balancing act for the government is to determine whether the additional revenue from new speculation taxes, which could be sizeable, will be large enough to counter the eventual decline in property tax revenue resulting from a sustained drop in housing prices.

But the real caveat applies to the unintended consequences when housing markets experience a steeper decline than was envisioned. The experiences in Toronto and Vancouver suggest that the uncertainty accompanying any change in regulations can spook even those who were not targeted by the new regulations.

Municipal governments must, therefore, build reserves while housing prices are rising. Why? Because, if there indeed are housing bubbles, they will be followed by busts.

Saving for bad times is equally important as spending in good times for smart local governments.